Monday, June 25, 2012

China and the shiny stuff

In my kleptocracy post I described how the range of investments available to the median Chinese family is limited. They can't take their money offshore (unless they are rich enough to afford casino junkets). The local stock market is rigged. There is no worthwhile mutual fund market. They can own see-through apartments. But their main saving mechanism is bank accounts and life insurance contracts (life insurance being a bank account proxy).

Rates are regulated - low. Inflation is high and ex-ante the return to Chinese savers is negative.

Despite negative real returns Chinese save in huge quantity. This may be because of the "four grandparent policy" as described in the kleptocracy post or because of gender imbalance (as described in the follow up post).

Whatever: in China we have huge quantities of savings at ex-ante negative real returns in some sense compelled by local social and political structures.

This pool of savings (part of what Ben Bernanke once described as the "excess of global savings") has global implications - and these will be explored in a forthcoming posts.

But here I state the obvious.

If you were forced to save huge amounts of money at negative real rates of return wouldn't gold look attractive?

Gold is a market I have studiously taken very little interest in. I agree with Warren Buffett - that it has no real return over very long periods and is thus unattractive. But in China no-real-return is a good return and until recently I had not thought about that clearly.

If people have a decent knowledge of the non-official gold-market in China please leave it (anonymously if you wish) in the comments.

Observations on gold demand in China now and in the future

I have no knowledge of the specifics of middle income people trading gold in China.

But I do note that inflation in China (with regulated low interest rates) is likely to be strongly positively correlated to gold demand in China.

Inflation in China is clearly declining right now (which is very bad for Chinese gold demand). However I do not think that falling inflation in China is likely to be sustained. Low inflation would result in the collapse of many State Owned Enterprises (and probably the regime) - and the regime is the hand that holds the printing press so to some extent inflation is a choice for the regime. They will print. And print. Their very lives depend on it.

This dovetails nicely into Krugman's analysis on gold prices -- that in periods of low real interest rates, it makes more sense to hoard gold: http://krugman.blogs.nytimes.com/2011/09/06/treasuries-tips-and-gold-wonkish/

Although I think he arrives at a different conclusion re: inflation expectations.

Gold demand in China and India is also driven by distrust in/lack of rule of law and tax avoidance, so real interest rates can rise and the demand will still be there.

Gold in this sense is a vote against the system for those without the power to change the system.

As Western countries increasingly become kleptocracies themselves, expect the same. From that point of view, the gold price is just the numbers of "votes" of those who feel powerless and pulling their wealth out, going "off the grid" financially.

Pettis pointed to a confusion between national savings and household savings in your first article.Relative to GDP household savings have not increased over the past decade. On the other hand government and enterprise savings have risen since 2002.In fact it happened often in history (with the interbellum as a good example) and financial repression exists when over a prolonged period wealth is channeled from the masses to the power elite (a rather unidentifiable group). The same imbalance exists in Japan and the IMF published a readworthy report on it http://www.imf.org/external/np/country/2011/mapjapanpdf.pdf I have no references for gold sales in China, but my impression is that gold sales are rising because of increased jewelry sales (luxury spending) and not because of investments.

I see where you are coming from with the inflation argument, yet at the same time, the central government talks a good game of bringing down inflation because they know that high inflation feeds into social instability. And the fact that it is down, year-over-year, has to give some support to the assertion that it is not all talk.

Warren Buffett... If not the government bailouts his company would be bankrupt. If all people invested according to his principles we wouldn't have any actual wealth producing industries. He did well in an environment of credit expansion and government bailouts.

Fine art doesn't produce anything either. So it has no value? Demand gives value to things and not a cash flow formula. Gold has properties that no other metal does: scarce, divisible, recognizable, not destroyed in industrial processes. These unique properties give it value. Just like with a Van Gogh painting.

This week's economist had an interesting article about fake/real luxury goods in China. Apparently the Chinese spend a way above average percentage of gdp on luxury goods in a battle to rise the social ladder. So maybe China's demand for gold isn't necessarily a result of poor investment options, but a result of demand for luxury goods?

They have already printed mate. For as much as they have complained about the Fed's QE, the PBoC has been doing QE for a decade, if you use central bank balance sheet expansion as a proxy for QE. Doesn't matter if you buy USTs, GSE debt, EUR/CHF, or Gilts, to me central bank balance sheet expansion at an inordinate pace over and above nominal aggregates like wages, CPI, wholesale prices, etc to me is QE, and every major central bank is doing it now.

If you don't believe that, then how do you explain Chinese M2 being greater than that of the US when the economy is about 1/3 to 1/2 the size? And if you still don't believe me, then maybe the PBoC's 1200:1 leverage will convince you.

The real question is not where a fair market CNY would be or when it's going there. The real question is why they haven't let it get there in the first place and somehow built up $3 trillion in FX reserves on the central bank balance sheet and in doing so is running a massive currency asset/liability mismatch (like the SNB). I suspect the answer has to do with subsidies that the SOEs need to stay solvent and pay back 'policy loans'.

Could Huawei compete with Cisco without a cheap export currency and without subsidized 'policy lending'?

In the current environment of capital flight, gold is an increasingly popular investment among middle class Chinese who don't have the connections to get their capital out of the country. They use it as a hedge against RMB denominated assets, not as a hedge against inflation.

Although credit growth rates have been high for most of the last 30 years, the Party is very wary of high inflation rates. First, because inflation directly affects the poor who spend half their income on living costs. Second, because the Party schools teach that high inflation contributed to the collapse of the Guomindang in the 1940s. Third, because the anti-inflationists won the internal Party debate in the 1980s, and the key pro-inflationists chose the wrong side on 4 June 1990.

Something like 50% of gold demand is from India and China. Recent gold weakness somewhat attributable to slowing demand there. The level of corruption in China also has an effect. When you do a stimulus that's 25% of GDP a lot of money falls through the cracks that cant exactly find its way into a bank so gold is an interesting choice of the very limited options. Additionally, and this is not necessarily my opinion, but gold could be perceived as a play on EM growth over last decade as that's where the marginal demand has come from. Potential sword of damocles over gold if India and China loosen their capital controls and permit other investments, who then becomes the marginal buyer.

If you want to have some insight into market demand for gold in China you can check out HK listed gold and jeweler retailers like Chow Tai Fook. They have 1600+ retail points in China. They sell gold, jewelry and watches. I have been to several of their stores and the majority of the products on offer are gold jewelry and gold decorations for festivals and celebrations.

They just announced a 79% jump in net profit to HK$6.34 billion and a 61% revenue growth to HK$56.6 billion (US$7.25 billion). They listed on the HK stock exchange in December 2011 and raised HK15.8 billion (around US$ 2 billion).

On my anecdotal evidence in BJ, gold is not a big middle-income investment strategy.

People put their trust in so-called 'human capital' - education and property (which leads to marriage and then grandkids).

I've got a friend who used to be a gold analyst here, and will try to get his take.

I'm also surprised that no one has mentioned the elephant in the room of Chinese property: no-one actually owns property, technically it's 70-year leases from the gov't, a system picked up from the Brits in Hong Kong (and to ease the consciences of hardliners). In practice, everyone talks and acts as though it's ownership. However, when you're thinking on the timescale of pensions and inheritance, then you need to take that into account (this was why the Brits started getting worried about HK handover in the late 70s). The HK gov't has occasionally changed the rules, and no-one has the foggiest idea what the Central government will do when the first leases run out around 2049.

John, I would be interested to read your thoughts on drillers such as MDI, GEO, EGD. These companies seem to be quite profitable, and should benefit directly with gold demand, yet could be better performers in terms of appreciation potential.

Potential for real exchange rate appreciation takes some of the edge off the case for gold in China and some other emerging markets. More interesting to buyers in highly indebted countries with strong incentive to inflate/depreciate currency.

The problem that I have with shorting MSFT is that the fix to this is so simple. They already built in the ability to make this look like Windows 7 by simply switching a setting.

The issue is that it defaults to the new Metro version, rather than the Windows 7 version. If they simply ship laptops & desktops to default to look like Windows 7 than the problem is solved. Those who want the Metro version can simply switch the setting.

What do you do if they make this simple change and the stock is higher?

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.